The Coming Global Instability, Part II (July 29, 2011)
Systemic causes of global financial instability include the "normalcy bias," super-low interest rates, central-bank induced inflation and loss of faith in institutions.
Some causal factors of global financial instability are mental constructs, others are pernicious policies. Money is the ultimate mental construct, of course; it is our faith in the promises issued by central banks and governments that gives paper money its value.
The same can be said of markets: it is our faith in their transparency which makes them "free markets." Once we discern that a market is manipulated, then we lose trust in it and exit that market for good.
The most pernicious policy is central-bank engineered inflation, which rewards debtors and punishes capital accumulation, a.k.a. savings. Push these incentives to debt hard and long enough, and you get a crippled, top-heavy economy like the U.S. economy, crushed by debts so staggering that the only way to service the debt is to borrow more money at insanely low rates of interest.
This is an excerpt from my new book An Unconventional Guide to Investing in Troubled Times which has just been issued in Kindle ebook format; a print edition will follow in September. (You can read the ebook now on any computer, smart phone, iPad, etc.--see below. The 30% discount expires tonight.)
Here are six systemic causes of global financial instability. (Here is yesterday's list: The Coming Global Instability, Part I.)
1) The human mind has a number of default settings which have proven advantageous as "short cuts" in most circumstances, one of which is called "the normalcy bias." As events spiral out of control and dangers rise exponentially, our tendency is to underestimate the risks and potential losses. As long as a few shreds of normalcy remain intact, we view these as evidence that “it’s really not so bad.”
Most of the time, this trait pays off as most systems are self-correcting and catastrophe is avoided. But when self-reinforcing negative trends take hold, this complacency is ultimately self-destructive.
2) The financial Status Quo, already discredited in the eyes of most well-informed observers, will eventually lose all credibility, and global stock markets will languish as participants abandon them.
If this sounds farfetched, recall that 70% of all shares traded in the U.S. stock market are exchanged in opaque “dark pools” operated by Wall Street and “too big to fail” banks, and high-frequency trading executed by “black box” algorithms account for the majority of the remaining 30% of publicly traded shares. This means that some 90% of stock market activity is hidden from non-insider investors.
The idea that we can rely on opaque markets for our financial security will increasingly be discredited. As heavy-handed interventions fail to restore stability, public faith in these institutions will decline. This delegitimization will further destabilize global markets, and those who accepted the implicit guarantees of stability, transparency and liquidity may find instead that their financial security has vanished in a cloud of “impossible” disruptions and dislocations.
This loss of faith is already evident. As the U.S. stock market doubled from its March 2009 lows, U.S. households withdrew hundreds of billions of dollars from domestic equity mutual funds, and quadrupled their holdings of “safe” U.S. Treasury bonds. If you look at a 10-year chart of volume in U.S. stocks, you will see a steady erosion of participation in the stock market. These are the actions of people who have lost faith in the stock market, the nation’s financial and political institutions and the official “story” of permanently rising prosperity.
Once trust is lost, it cannot be won back easily or quickly.
As the financial authorities attempt to keep the system from crumbling beneath their feet, they will take increasingly drastic actions as markets destabilize: investment rules that were presumed to be eternal will be changed overnight, without warning, and then changed again. Decades of low volatility that encouraged people to buy long-term bonds, annuities and dividend-paying stocks will be upended by unprecedented financial and political volatility. Seemingly permanent low interest rates that lured investors to pile into high-risk gambles will suddenly leap up, wiping out gamblers who weren’t even aware they were playing a game rigged in favor of the “house.”
Such expectations are well-grounded in history. Most investors have forgotten that the U.S. stock market was summarily closed for months during World War I, and that in 1933, the Federal government seized “hoarded” privately held gold. These actions were, at the time, considered necessary and prudent by the authorities. More recently, in 2008 speculating that banking stocks would decline (that is, shorting banking stocks) was summarily banned. The rules governing the market were changed to defend the Status Quo, and speculation was only allowed if it flowed in one direction—the one favored by the financial authorities.
3) Stripped of mumbo-jumbo, central banks and States have only two buttons to push: Keynesian fiscal stimulus, i.e. governments borrowing and spending vast sums in an effort to stimulate demand and the “animal spirits” that drive private borrowing, and monetary easing, i.e. lowering interest rates to near-zero, and printing or creating credit electronically to flood the economy with “liquid,” easy-to-borrow money.
Central banks and States are hitting these two buttons like frenzied laboratory rats, but the machine is out of cocaine-laced pellets. In effect, central banks and Central States are both addicted to exponential expansion of credit, intervention and Central State borrowing and spending. Each is only exacerbating the system’s risks, and as the authorities ratchet up these interventions to ever-higher levels, they’re insuring an even greater collapse.
There is a pernicious agenda at work in setting interest rates near zero while boosting money supply and deficit spending to create inflation. By robbing savers of any return on their savings and sparking “sustainable, orderly” inflation of around 4%, central banks are in effect transferring 4% from the owners of cash to reduce the debt of the central bank/State by this same amount every year. In a decade of this monetary scheme, savers’ wealth will be reduced by roughly 50% while the debt created by the central bank/State will decline by 50%.
“Purchasing power” is a concept while helps us understand the results of low interest rates and “politically benign” inflation: the owner of cash will find their money buys only half of what it did ten years before, while the government debt has also fallen in half. The net result of this slight-of-hand is that government debt that was crushing becomes manageable again as savers’ wealth was invisibly transferred via carefully engineered inflation.
The key phrase in this sub rosa agenda of transferring private wealth to reduce government/central bank debt is “politically benign:” since the loss of wealth and the rise in consumer prices is “only” 4% a year, the consequences are not severe enough to trigger political resistance. Financial and political authorities know that people quickly habituate to an “orderly” reduction in wealth and an “orderly” inflation in prices; that is, this erosion of purchasing power soon becomes “the new normal” and people plan around it.
The purpose of this central bank/State agenda is to avoid the two endgames that would destabilize the Status Quo: outright default on the Status Quo’s staggering debts, and hyperinflation, or loss of faith in a paper (fiat) currency. Either of these events would destroy the credit markets that form the foundation of the global economy.
We can see how successful this strategy of engineering orderly, “normal” inflation has been: 30 years ago, a Federal debt of $15 trillion would have unimaginable. Today, it is accepted as “sustainable” because it will never be paid back in today’s dollars, and low interest rates insure that the carrying costs of that debt remains small enough that no other government spending need be sacrificed to pay the annual interest.
This agenda has worked like magic for the past 30 years, but beneath the apparent success, the foundations of the current system-- cheap energy, globalization, financialization, monetary expansion, fiscal stimulus, opaque markets and constant State/central bank intervention--are all eroding. As they dissolve then so too will the Status Quo’s implicit promises of permanent stability, low interest rates and limitless growth.
The point here that the levels of intervention required to create inflation in a deflationary, deleveraging-of-debt era are not just stupendous-- they must ratchet up to ever higher levels to maintain superficial stability as the system becomes increasingly precarious. Ironically, increasing the heavy-handed centralized interventions only increases the system’s precariousness—the exact opposite of the Central Planners’ intentions. This is the result of trying to manage non-linear systems with linear-system tools: all that manipulation can achieve is to extend surface stability at the cost of a more severe system crash later on.
4) The investment world is keen on probabilities as reliable guides to the future. But low-probability events occur with remarkable regularity, so it’s prudent not to put too much faith in statistical or probabilistic reassurances. All such models are based on the idea that the recent past is a reliable guide to the future. But if the thesis that the next 20 years will necessarily be very different from the previous 60 years, then this faith that the recent past offers a roadmap of the future is dangerously misleading.
5) The uneven, unpredictable process of destabilization and devolution will play out over many years as periods of apparent stability are punctuated by the re-emergence of crises which were supposedly resolved in the previous cycle of central bank/government intervention. Every era of stability will be less enduring than the last, and come to rest at a lower level of security and prosperity than the last. Every intervention will be larger, more desperate and more intrusive than the last, and much less effective.
6) Periods of creative destruction are inherent to Capitalism, indeed, essential to its long-term success. Just as we cannot fool Mother Nature for long--for example, by reckoning we can eliminate forest fires--we cannot manipulate the global economy to eliminate creative destruction. All the unprecedented efforts of central financial authorities to eliminate risk and instability are simply piling up more deadwood in an already tinderbox forest.
Financial risk is like water in a closed system: it cannot be compressed. As pressure mounts, the risk builds up and eventually escapes, often through whatever part of the system was considered “safe.”
Periods of great transition in which existing systems are consumed by creative destruction and a new paradigm emerges offer great opportunities as well as great risks.
If I had to summarize this book in a few sentences, I would say this: Money is a tool; make it work for you. Don’t invest in Wall Street’s false promises, invest with an unblinking eye on systemic risk. Invest in your own life and in the lives of others. This book explores how to do just that.
TWO SPECIAL ANNOUNCEMENTS:
My new book An Unconventional Guide to Investing in Troubled Times is available in Kindle ebook format. You can read the ebook now on any computer, smart phone, iPad, etc.--see below.
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